Public Information Notice No. 02/74

Public Information Notice: IMF Concludes 2002 Article IV Consultation with Panama

July 18, 2002

On July 10, 2002, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation with Panama.¹

Background

Real GDP growth slowed for the third consecutive year to 0.3 percent in 2001, compared with 2.5 percent in 2000, and 3.2 percent in 1999, reflecting both the slowdown in the global economy and a deceleration in domestic demand, which resulted mainly from the winding up of large investment projects and the sharp deceleration in bank credit to the private sector, following an unsustainable acceleration in 1998-99.

The slowdown in economic activity was not even across sectors. Some sectors, most notably nontraditional agriculture, telecommunication, transport (including ports), and finance experienced robust growth, while other sectors, including traditional agriculture, manufacturing, commerce, and construction declined. Because the growth sectors tend to be relatively capital intensive and favored by tax incentives compared with the declining sectors, the unemployment rate rose from 13.5 percent in 2000 to 14.4 percent in 2001 and tax revenue declined by 7 percent. Also reflecting the weak domestic demand, inflation declined 0.7 percent to 0.3 percent and the external current account deficit shrank from 9.3 percent of GDP to 4.9 percent. Economic activity in the first quarter of 2002 continued to be weak, with real GDP growing by 0.8 percent compared with the same period a year ago. However, April and May taxes brought the year-to-date tax collections above the corresponding levels of 2001, possibly suggesting the beginning of a pick up in activity.

Despite efforts to contain spending by the central government (current noninterest spending declined by 0.3 percent of GDP), Panama's fiscal performance deteriorated in 2001, with the nonfinancial public sector deficit widening to 2.5 percent of GDP from 0.7 percent of GDP in 2000.² The worsening of the fiscal position reflected mainly negative cyclical factors that exacerbated existing negative structural trends in both tax revenue and the finances of the social security system. Tax revenue and social security system finances continued to worsen in the first quarter of 2002, and the nonfinancial public sector registered a deficit of 2.3 percent of GDP compared with a deficit of 1.6 percent in the first quarter of 2001.

During 2001, an active public debt management policy led to the issuance of US$1.1 billion of sovereign bonds to cover not only amortization of external debt, but also the retirement of some domestic treasury notes, a buyback of some Brady Bonds, and a pre-funding of the maturing US$500 million February 2002 global bond. Total debt of the nonfinancial public sector stood at 70.1 percent of GDP at end-March 2002.

In May 2002, following agreements reached in the National Dialogue for the Reactivation of the Economy, the Assembly approved a law authorizing the Fiduciary Fund to use up to US$200 million of its US$1.25 billion assets to finance specific infrastructure projects and invest the remainder in existing Panama global bonds. The law also established a deficit ceiling of 2 percent of GDP for the nonfinancial public sector as well as constraints on the growth of net debt to ensure its gradual decline over the medium term.

Panama has achieved substantial progress in strengthening the supervisory and regulatory framework of the banking system, which has displayed resilience to the difficult domestic and regional environment. The average risk-weighted capital to asset ratio stood at 15.5 percent in March 2002, well above the regulatory minimum of 8 percent. Nonperforming loans increased during 2001 but still remained small, at 3 percent of total loans in March 2002, and are almost 100 percent provisioned. In August 2001, an IMF Offshore Financial Center Module II assessment found Panama to be compliant with 23 out of 25 Basel Core Principles, including those related to anti-money laundering. In June 2001, the FATF removed Panama from its list of noncooperating countries. In April 2002, Panama was removed from the OECD list of noncooperating countries related to Harmful Tax Practices.

Executive Board Assessment

Directors noted that during 2001 inflation remained low, the external position improved, and progress was made in strengthening the regulatory framework of the financial system. However, output and employment were adversely affected by the slowdown in regional markets and the global economy, while the fiscal and debt situation had deteriorated. Also, the reform agenda, especially as regards the tax and the social security systems, had continued to lag.

Directors remarked that, in an uncertain external environment, the pursuit of sound fiscal policies and a decline in the public debt ratio were crucial for maintaining macroeconomic stability, reducing country risk, and creating conditions favoring more rapid output growth. In this connection, they welcomed the steps which had been taken to limit the deficit of the nonfinancial public sector in 2002, as called for under the recent fiscal responsibility legislation. Some cautioned, however, that undue reliance on capital expenditure cuts could adversely affect Panama's growth prospects —as well as the already high unemployment rate —and suggested that emphasis be placed on tackling promptly structural weaknesses in the fiscal area. In particular, it is essential to address the fiscal problems caused by the structural decline in tax revenue, the actuarial imbalance of the social security system, and the automatic increases in the wage bill, all of which could affect compliance with the new fiscal rules.

Directors urged the authorities to press ahead —in the context of the ongoing National Dialogue —with their efforts to implement a revenue-enhancing tax reform, broaden the tax base by reducing exemptions, strengthen enforcement, and extend the VAT to cover services. They welcomed the government's recent statement outlining broad proposals to address the financial problems of the social security system, and hoped that this would provide the impetus for agreement on a comprehensive plan to put the system on a sound financial footing. Directors encouraged the authorities to work toward phasing out the special laws that provided for automatic wage increases to various categories of civil servants. They also emphasized that fiscal sustainability will require a clear, medium-term debt management strategy.

Directors welcomed the substantial progress made in recent years in strengthening the supervisory and regulatory environment for commercial banks. They also commended the authorities for their efforts to combat anti-money laundering and terrorism financing, and to implement staff recommendations, including as the key next steps, upgrading procedures for onsite and offsite inspections, and strengthening the supervisory and regulatory framework for insurance companies and other nonbank financial institutions. Some Directors expressed concern about the soundness of the Agricultural Development Bank, and the National Mortgage Bank, and urged that attention be placed on improving their loan quality. Directors also recommended the undertaking of an FSAP, particularly to review the operations of the non-bank financial institutions. In addition, some Directors encouraged the authorities to consider the introduction of a deposit insurance scheme.

Directors stressed that achieving debt sustainability, as well as alleviating unemployment and poverty, required faster rates of economic growth. They encouraged the authorities to take steps to make the economy more competitive by undertaking a comprehensive review of existing laws and regulations aimed at modifying those that create distortions by discouraging job creation and investment. In this context, it would be important for the authorities to follow through expeditiously in implementing the reforms that will be proposed under the Competitiveness Project supported by the Inter-American Development Bank.

Panama's economic and financial statistics are generally adequate for surveillance and program purposes, and Directors encouraged the authorities to address remaining weakness in the national accounts, the balance of payments, and private sector debt.